From Boom to Bust

Since the 1850s gold rush, San Francisco's development has been a series of booms and busts. What's new about the latest bust is the culprit. Unlike prior downturns when developers were the fall guys for overbuilding, this time the blame goes to Internet and high-tech companies whose skyrocketing stock prices and long-term lease commitments turned out to be fool's gold.

This year, soaring amounts of office sublease space, plunging hotel occupancy rates and steady job losses — 60,000 employees in the first half of the year — were as San Franciscan as cable cars and fog. All forms of Bay Area real estate, with the exception of residential, have gone into a free fall. In San Francisco's central business district, the office vacancy rate jumped from 12.1% in the second quarter of 2001 to 20.3% in the second quarter of this year, according to BT Commercial, a regional brokerage. BT pegs the Central Silicon Valley office vacancy rate at 17.4% at mid-year, compared with just 8.9% at mid-year 2001.

Asking rents for Class-A office space in San Francisco plummeted from $54 per sq. ft. at mid-year 2001 to $28.18 per sq. ft. this year, according to the San Francisco office of Julien J. Studley Inc. At the height of dot-com mania, soaring rents in excess of $65 per sq. ft. enticed developers to venture from the CBD and build in a grittier section of downtown known as South of Market Street.

Lured by the decreasing rental rates, tenants are creeping back into the market, but most analysts and developers see the recovery moving at a glacial pace because of the nearly 7 million sq. ft. of sublease space in the city alone.

Colin Yasukochi, research director in the San Francisco office of New York-based Grubb & Ellis, doesn't expect solid improvement for two years. Mark Ritchie, president of San Francisco-based Ritchie Commercial, predicts there won't be a new round of office development in San Jose for at least six years. And University of California economist Ken Rosen says there is no quick fix for San Francisco's real estate woes.

“We won't see net positive absorption until mid-2003,” Rosen predicts. “The best case scenario for a full recovery is three years. The worst case is five years from today.”

There are 14 office projects that have received zoning approval in San Francisco, but many have no construction start date because financing is impossible without an anchor tenant. The city is much more active on the residential front with 22 projects under construction, 23 approved and 21 in the planning stages.

Luke Skywalker to the Rescue

Despite the office downturn, there are several big projects moving forward in San Francisco. Star Wars movie mogul George Lucas and his Lucasfilm Ltd. are in the early stages of building a 900,000 sq. ft. digital arts campus in Presidio National Park, located on the city's northwest waterfront bracketed by the Golden Gate Bridge and Fisherman's Wharf. The proposal for a new Lucasfilm headquarters is a controversial project with environmental groups attacking its size and the blasphemy of an office campus in a national park.

Demolition of the former army hospital on the site is now complete and the project's design is under review. The campus is expected to be built by 2005 at a cost of $300 million.

Meanwhile, Sydney, Australia-based Lend Lease Corp. is negotiating with the city's Port Commission to build a new 100,000 sq. ft. cruise ship terminal along the waterfront's decaying piers that would include a 350,000 sq. ft. office building, 389 residential units and 250,000 sq. ft. of shops and restaurants. All of the buildings in the $500 million project would be less than 20 stories. Lend Lease's financial partners are Singapore's Port Authority and Taiwan's China Maritime Transport. The team plans to break ground on the residential units in 2003.

The only major office project to break ground thus far in 2002 has been the federal government's 18-story, 600,000 sq. ft. office building downtown. The building features a spectacular glass design and hanging gardens. It will cost $142 million and consolidate 1,700 federal workers in the city. The building could be a catalyst to revive the long downtrodden section of Market Street that connects the financial district to the Civic Center, says John Nolte, project director for the General Services Administration.

Mission Bay as Second City?

The building boom of the late 1990s led to five new high-rise office towers, the San Francisco Giants' Pacific Bell Park and nearly a dozen condo towers. But to tear down any building in this highly politicized city and redevelop it often takes several years. Mission Bay is the best example.

Located one mile from downtown on the city's southeastern waterfront, Mission Bay has spurred a namesake project that would transform 303 former industrial acres into 5 million sq. ft. of new office, residential and educational buildings. Catellus Development Corp., San Francisco, is trying to create a second downtown, but it will take at least another decade for the full buildout.

SAN FRANCISCO VACANCIES

2nd quarter 2001

2nd quarter 2002

Office (CBD)

12.1%

20.3%

Source: BT Commercial

Industrial

4.8%

11.7%

Source: CB Richard Ellis

Multifamily

2.7%

5.6%

Source: M/PF Research

Retail

4.65%

5.75%

Source: Marcus & Millichap

Unless otherwise noted, statistics provided are for the metro area.

The project has been 15 years in the entitlement stage, but construction is under way on Phase I, which will cost $1 billion. Unlike most large U.S. developments where an office complex or a ballpark is the anchor, education and housing are the catalysts of Mission Bay. Developers hope biotech companies will flock to the medical research campus now under construction at the University of California at San Francisco (UCSF). Multifamily projects will spark retail in South of Market, an area of the city that has never had a major supermarket or any large retail chain.

Three developers, including Catellus, are constructing three high-rise apartment towers that will translate into 979 apartment units at a cost of $800 million. Construction is expected to begin next year on another 840 units. Safeway Inc. grocery stores and the Borders Group Inc. bookstore chain have signed leases with Catellus to become retail anchors along the King Street corridor, a short walk to Pacific Bell Park.

The office component of Mission Bay has been problematic. Development ground to a halt in late 2001 and hasn't picked up since. Catellus had originally begun work on a speculative building after landing Gap Inc. to a 240,000 sq. ft. lease. The Gap building is now built, but its entire space ended up on the sublease market after the San Francisco-based retailer's business shrunk. Catellus has suspended all construction on office buildings until it can find tenants.

Tackling the Housing Shortage

For over a decade, the city has not approved enough housing to meet demand, which has created a shortage. But several projects are in the works.

Local developer Union Property Capital has a plan before the city for two 35-story apartment towers that would contain a total of 860 units. To meet his affordable-housing quotient, Union is partnering with several churches to build the affordable units on church property. In another high-rise project, New York-based Tishman Speyer Properties has an option to purchase 201 Folsom and plans to build an 806-unit, 36-story condo tower.

New York-based Millennium Partners, which built nearly 200 luxury condo units above its Four Seasons Hotel on Market Street last year, is back before city planners with a proposal to build a 260-unit condo tower at 301 Mission that would likely cost in excess of $100 million.

The most consistent developer is Oz Erickson, whose San Francisco-based Emerald Fund has been able to build in good times and bad. Erickson is now building more than 650 units in three separate projects, including his Ocean View Village, which is a 300-unit rental complex near a train station between downtown and San Francisco International Airport.

An emerging trend has been the conversion of office buildings to residential space, and several developers are pursuing that strategy, mainly with Class-B office buildings. Tishman Speyer is in the early stages of converting the former Chevron office building at 575 Market St. downtown into a 20-story condominium tower.

Chevron left the city for cheaper office space in suburban San Ramon, badly hurting the city's psyche. Tishman overpaid for the Chevron tower at the height of the high-tech boom market and is trying to salvage its investment by going condo. Tishman paid close to $200 million for the building, but brokers say its value has dropped by about 40%.

Retail Market Reeling

The impact of Sept. 11 continues to dampen the city's tourism business, hurting retailers on Union Square, San Francisco's shopping hub. Gone are some big names, including DFS Galleria, Celine, Timberland and Bally, whose sliding sales couldn't justify $1 million per year in rents.

The city's biggest retail development is the planned 1.3 million sq. ft. conversion of a section of the old Emporium building into a mall featuring the largest Bloomingdale's west of Manhattan. But the project has been on hold for more than a year and there is no clear indication when construction will begin.

The developer has been delayed by a lawsuit from historic preservationists and is waiting for the legal smoke to clear before trying to lease up the mall portion of the project. Bloomingdale's remains committed and is eager to build a West Coast flagship. A hotel and condo tower is also bundled into the $300 million project.

Williams-Sonoma has signed a lease to occupy the 3-story Bullock Jones building on Union Square and plans to convert it to its San Francisco flagship. The building has sat vacant since February 2000, a glaring retail eyesore and a sign of the bad times. Williams-Sonoma will likely open in 2003 after a multi-million dollar renovation.

Hotels: Dim Prospects

The occupancy rate in San Francisco hotels plummeted to 61.8% in the second quarter of the year, down from 69.8% at mid-year 2001, according to San Francisco-based PKF Consulting.

A total of 28 hotels opened in Northern California in the first half of the year, with most of the action taking place in Silicon Valley, East Bay and Sacramento, according to Costa Mesa-based Atlas Hospitality Group. Only two new hotels are under construction in San Francisco.

Locally based Kimpton Hotel Group Inc. plans to open the 268-room Argonaut Hotel downtown in spring 2003. White Plains, N.Y.-based Starwood Hotels & Resorts Worldwide Inc. is building the St. Regis at Third and Mission Streets downtown, and the 275-room hotel is likely to open in 2004.